Black Edge: Inside Information, Dirty Money, and the Quest to Bring Down the Most Wanted Man on Wall Street

by Sheelah Kolhatkar

  The next morning, Bowe strolled into a conference room inside 1 St. Andrew’s Plaza in downtown Manhattan. Kang was at one end of the table and an investigator from the SEC was at the other. Cantwell was in the middle. She pointed toward a chair and Bowe sat down. None of them looked happy.

  “What would you like to know?” he asked.

  Cantwell said that the U.S. Attorney’s Office was investigating Fairfax for possible fraud. She said that Fairfax, and Bowe, should have waited to file Fairfax’s lawsuit until their criminal investigation was resolved. The lawsuit had just created major problems for their case. Was the government supposed to be looking into possible allegations of fraud at Fairfax or criminal activity of short sellers at hedge funds who were shorting Fairfax stock? Cantwell wanted Bowe to explain every aspect of Fairfax’s 160-page complaint.

  Bowe spent the next three hours describing the charges and the evidence behind them, telling them about SAC and the other hedge funds Fairfax believed were targeting them, the false rumors and prank phone calls, the short selling and the allegations of insider trading. While he spoke, Kang took notes.

  The atmosphere was chilly, but Cantwell said that they would look into Fairfax’s claims against the hedge funds. She thanked him and said goodbye.

  —

  Michael Bowe was not raised to avoid conflict. In some ways he sought it out. Most everything he knew about life he’d learned growing up in Pearl River, a town an hour north of Manhattan crammed with Irish bars and knickknack shops. At recess, eight hundred children of New York City cops and firefighters would extrude from the Catholic elementary school in town into an asphalt schoolyard where a teacher looked the other way as the kids took turns picking on one another and concocting cruel games.

  After school, they roamed the streets in packs, getting into fistfights and trying to make each other cry. It was there that Bowe developed some crucial skills: how to deal with people who had it in for you, how to be the big guy in a situation as well as the little guy, how to overcome adversity. Bowe’s father had been a fireman with Ladder 36 in Inwood, in northern Manhattan, until he was badly burned in a fire and retired. His petite Irish American mom would hoist her young son up onto the kitchen counter after he came home crying from a neighborhood beating. “Michael,” she’d say, “you need to learn to take care of yourself.” He did not go on to get an Ivy League degree like most of the federal prosecutors in the U.S. Attorney’s Office in Manhattan. Bowe was a proud product of Fordham and New York Law School, and conflict didn’t faze him.

  By the time B. J. Kang called him again to follow up on the hedge fund allegations, four months after their initial meeting, Bowe had become the world’s living expert on SAC Capital Advisors.

  “We were wondering if you could come down and walk us through what you’ve learned about SAC and other hedge funds and the insider trading you see out there,” Kang said. He especially wanted to know about what Bowe had referred to as the “insider trading business model” he believed many hedge funds employed. Would he let the FBI agent ask him questions for a couple of hours?

  Sure, Bowe said, he’d be happy to.

  Kang was still new at the FBI’s securities fraud unit. Until then he had been assigned mostly to cases involving small brokerage firms, many of them located outside of New York City in strip malls, where salesmen pitched worthless penny stocks to people who didn’t know enough not to take stock tips from strangers over the phone. The amounts of money involved were negligible, and each time the FBI shut one down, another one popped up in its place. Kang’s boss, Pat Carroll, had a feeling that there was more going on, bigger cases involving significant frauds they should be pursuing. He had recently called Kang into his office to tell him about it.

  “The pyramid schemes and pump and dump cases are all fine,” Carroll told him, by way of a pep talk. “But we need to start looking at hedge funds. The industry is not very transparent, and we haven’t really looked at them before.”

  Kang nodded, not quite sure that he understood.

  “If you follow the money, hedge funds are where it leads,” Carroll explained. He wasn’t saying that all hedge funds were breaking the law, but he was concerned that the FBI didn’t have a clue as to what these funds were doing and how they were making so much money. New ones were opening for business every day, and billions of investor dollars were flowing into them. “We need to start thinking big,” Carroll said.

  Kang had wanted to work in law enforcement since he was a kid in suburban Maryland playing cops and robbers. He had fused this good guy–bad guy obsession with a practice his parents had drilled into him growing up, to work harder than anyone else until he succeeded. If the guy at the desk next to him showed up at 7 A.M., Kang would come in at 6; if the other guy started coming in at 6, Kang would show up at 5:30. When he graduated from the FBI Academy, he asked for a placement in New York, which was where the most important cases happened.

  The first thing Kang did after Carroll’s speech was try to educate himself about the hedge fund industry. He was familiar with the most prominent fund managers and the incredible amount of money they seemed to be making. He was vaguely aware of Galleon, Raj Rajaratnam’s fund, which was one of the top performers in the industry. But there was a lot more he still had to learn.

  During interviews with informants and witnesses from the financial world, Kang always asked the same questions: Who are the most successful hedge fund traders? How do they make their money? Do people think they’re clean? One name came up over and over again: SAC Capital.

  SAC, according to Kang’s sources on Wall Street, was the most profitable, and aggressive, fund out there. Its competitors couldn’t understand how SAC was able to make 30, 40, 50 percent year after year, apparently without ever suffering a loss. It seemed too good to be true. Kang wanted to know more.

  He and Bowe spent most of the afternoon alone in a conference room, as Bowe explained how he thought the hedge fund world worked.

  The way Bowe saw it, Wall Street had undergone an enormous shift over the previous five or six years, unbeknownst to the people responsible for policing and regulating it. The capital markets system existed to help channel capital that people had to invest to businesses that needed it to build bigger plants and develop new products and hire more workers. This system was the engine for economic growth. Banks made loans, while investment banks made the engine run by facilitating stock and bond trading, IPOs, and mergers and takeovers. Up until 2000 or so, the market was dominated by a handful of these large firms, with names like Goldman Sachs and Morgan Stanley, as well as mutual fund companies that managed people’s retirement accounts. And all of them operated under an umbrella of rules and regulations that had been in place for almost seventy years. There were, of course, regulatory violations and even criminal activity taking place, but it was mostly happening in well-defined, predictable ways. The big banks, for the most part, understood what was legal and what wasn’t and had compliance departments in place to make sure they didn’t run too far afoul of the law. The SEC knew what it was supposed to be looking for when it monitored them.

  Over the previous ten years, however, billions of dollars had moved out of the heavily regulated big banks and into hedge funds, which were aggressive investment vehicles promising enormous returns. Hedge funds were subject to only light regulation, and most operated behind a veil of secrecy. “When you look at the nature of the regulatory cases that have been brought against the big banks—I’m not saying the conduct wasn’t bad,” Bowe told Kang. “But a lot of the cases involved stepping over a line that was far away from the type of stuff going on at the hedge funds.”

  Look at it in practical terms, Bowe said. Many of the people working at these funds had unconventional backgrounds; their main qualification might be that they were buddies with the fund manager, and they couldn’t have gotten a job at Goldman Sachs if they’d tried. These hedge funds weren’t under the big regulatory umbrella, they didn’t always have real complia
nce departments, and the philosophy was to hire anyone who could make money trading, regardless of how they did it. The SEC had only minimal information about them. Given all this, what did Kang think was going to happen?

  In the course of investigating the industry on behalf of Biovail and Fairfax, Bowe had become convinced that hedge funds were incubating a new and virulent form of corruption. At the same time that high finance was inventing a nearly incomprehensible new array of financial products and instruments, collateralizing mortgages and other debt and turning it into securities, traders were finding new ways to cheat. When it came to innovating financial crime, hedge funds were like Silicon Valley.

  Government intervention had made matters worse, in a classic example of unintended consequences. In 2000, New York attorney general Eliot Spitzer launched an investigation of research departments at Wall Street investment banks, ultimately charging them three years later with manipulating their buy and sell ratings on stocks, the same ratings that many investors in the market turned to as guides when evaluating the health of various companies. Spitzer accused the banks of using their analyst reports as sales tools to generate investment banking business for their firms. At the time, underwriting initial public offerings and advising on mergers and takeovers provided the bulk of most big firms’ profits. Promising a positive report on a particular company was an effective way of paving the way for more advisory fees on deals.

  The classic case was Henry Blodget, the star Internet analyst at Merrill Lynch who said in 1998 that he believed shares of Amazon were worth $400. He publicly praised companies like Pets.com and eToys.com while his firm courted business from them. In private emails to colleagues, however, he said that he really thought the companies were overhyped, calling Excite@Home “a piece of crap” and other dotcom companies “dogs.”

  When the attorney general’s office exposed these conflicts of interest and settled with Merrill Lynch, Goldman Sachs, Lehman Brothers, J. P. Morgan, and the six other top Wall Street firms at the end of 2002, it extracted billions of dollars in fines and restitution as well as promises from the banks to abide by a new set of tighter rules. Investment banking and research departments had to be completely separate from one another, and analysts could no longer be paid in relation to how much banking business they generated for their firms. Almost overnight, the job of being a Morgan Stanley or Goldman Sachs technology analyst went from being one of the most desirable positions in the financial industry to that of a glorified librarian.

  As this was happening, hedge funds were becoming increasingly important to the big banks because of the volume of trading they did. Their commissions became a major source of profit. The hedge funds demanded service in return for the hundreds of millions in fees that they paid, and the big firms started to do whatever they had to to keep them happy. The most aggressive hedge funds wanted to know if an analyst was going to downgrade or upgrade a stock before anyone else. A skilled trader—and even a not-so-skilled one—could turn that information into instant profits.

  Meanwhile, in response to calls from Spitzer and others for independent stock research, boutique research firms started up, promising unbiased opinions about whether investors should buy or sell stock in certain companies. At first, this seemed like a good idea. But these little research shops didn’t have big compliance departments, either, or much in the way of a reputation to protect. Some employed analysts who were barely qualified for the job. What was to stop a powerful hedge fund from coming along and saying it was going to buy the little firm’s research reports and then suggesting which companies it wanted to read about, even what it wanted the research reports to say? Bowe believed that hedge funds could easily manipulate the market by commissioning negative reports on companies whose shares they were already short and then making a profit when the negative research drove the stock price down.

  Finally, Bowe told Kang about expert networks like Gerson Lehrman Group, the matchmaking company that helped connect investors with executives at publicly traded companies. Hundreds of doctors involved in drug research and middle managers at technology companies were moonlighting for these expert network firms, taking money to have “consultations” with hedge fund traders. The consultants weren’t supposed to disclose confidential information, but there was little in place to prevent that from happening. Hedge funds were paying millions of dollars in fees to these consultants. Why would they do that for information that anybody could get? This in particular struck Bowe as an arrangement that could easily be misused.

  They talked for four hours. For Kang, it was like learning a new language. He scribbled on a legal pad and interrupted Bowe to ask questions, saying, “Hold on,” “Back up,” and “Could you please repeat that?”

  He was astonished at just how unethical the business seemed to be.

  “We both know that if you have tons of money at stake and nobody is watching, you will find bad conduct,” Bowe said. On Wall Street, he argued, you were likely to find a range of misdeeds: some close to the line, some over it, and a few that went way beyond. The worst stuff, Bowe was convinced, was happening at hedge funds.

  “You don’t have to believe me, you just have to go and look, start talking to people,” he said. “This is like gambling at Rick’s. If you start picking up rocks and looking under them, particularly with respect to SAC, you’re going to find it.”

  * * *

  * SAC and the other hedge funds won dismissal of the case. The court found that SAC had no economic interest in the scheme. Fairfax appealed in 2013.

  CHAPTER 5

  EDGY, PROPRIETARY INFORMATION

  There were many advantages to working at one of the most envied firms on Wall Street, as SAC was, but its employees often felt like they were part of an experiment looking at the effects of prolonged stress and uncertainty. There was continuous scrambling and reshuffling of the computer terminals and the seating chart, and the hierarchy that accompanied it, which meant that no one ever felt secure. The possibility of a career-ending loss constantly hung over a portfolio manager’s head. People who visited the offices regularly were startled to find that entire desks or departments had disappeared without explanation. But all that change created opportunity, and Michael Steinberg intended to make it work for him.

  Steinberg had started working at SAC in 1996 as a clerk to Richard Grodin, Cohen’s treasured technology trader. Tall and broad-shouldered, with the preppy affect of a college lacrosse player, Steinberg could be seen bent over the trading desk, writing Grodin’s trade tickets, jumping on the phone with brokers if there were problems with trades, and generally doing whatever the guys above him wanted, no matter how small. Steinberg’s parents were worried when he majored in philosophy in college because it seemed so impractical, and he was determined to show them that he could become a success at something that would bring financial security. Gradually, he was promoted at SAC, and by 2004 he was running the portfolio alongside Grodin. Once Grodin quit, after his dispute with Cohen over sharing C. B. Lee’s research, Steinberg was put in charge of the portfolio on his own.

  He set about trying to find good people to work with. As a portfolio manager, Steinberg was responsible for assembling his own team of analysts and traders, who would help him manage his allotted pool of capital. In September 2006, a thirty-six-year-old analyst named Jon Horvath joined his group, hired to research computer-related stocks like Dell, Apple, Intel, Microsoft, and IBM. The hiring process had lasted six months and involved at least a dozen interviews with ten different people. Horvath went stoically through it, knowing that if he got the job, he could work for a few years and then spend the rest of his life skiing.

  Horvath looked like he was stoned half the time, but he was a hard worker. His job was to propose trading ideas to Steinberg—but not just any trading ideas. The SAC approach, he quickly learned, was to seek out investment opportunities where a specific event like an earnings announcement would move the price of a stock up or down. The trick was to figure out w
hat that event was and how to set up a long or short position to benefit from it. Horvath built elaborate spreadsheets and earnings models. He had an apartment in San Francisco, near Silicon Valley, and he traveled back and forth between New York and the West Coast as well as to investment conferences and technology companies all over the world, trying to learn everything he could about his companies.

  Horvath had been at SAC for only a few months when, in early 2007, there were stirrings of trouble in the economy. Real estate values across the country had started to decline and mortgage delinquencies were spiking, imperiling the banks and other investors that had bought up large amounts of mortgage debt on the assumption that housing prices could only go up. Most investors chose to ignore the signs of impending disaster, however. Rather, they were acknowledged only by those who were open to the possibility that their rapid accumulations of wealth hadn’t made them infallibly brilliant. In May, two hedge funds owned by Bear Stearns that were heavily invested in subprime mortgage bonds started to plummet in value. Each had been worth more than $20 billion—and then, in a matter of weeks, no one in the market wanted anything to do with the mortgage securities they owned. Bear Stearns management tried to support the funds, but the value of the securities continued to plunge. On July 18, Bear announced that the hedge funds were essentially worthless and that it was shutting them down, leading to billions of dollars in losses.